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Suppose they had a trade war and nobody came

13 August 2019

The relationship between the Sino-American trade war and US inflation is a complex one. But what would happen if the trade war was called off tomorrow? Business as usual?

Funny time for a rate cut, isn’t it? Never in history has the Fed started to cut rates from such a low level (Mario Draghi: ‘hold my beer and watch this’) – the economy, stocks and employment all so strong, you’d be tempted to think that rate hikes would be in order.

The two favourite explanations are the increased politicisation of the Fed, more on that in a later piece, for now lets just point out that with the imminent appointment of Lagarde at the ECB only 2 G7 countries will have a central bank governor who has actually studied economics. And they are both Canadian. Or that the Fed is pre-empting a big down-turn as a result of the trade war.

I’ve got two questions about that. What is the relationship between inflation and a trade war? And what would happen to inflation if the trade war doesn’t happen?

Tariffs increase the cost of imports. Easy enough. The increase in global trade in the last twenty years has been the single most deflationary force in the world since the 1970s. The effect of the tariffs will be only slightly mitigated by the substitution of domestic products (which is what it’s all about really) and imports from non-tariff countries, and slightly mitigated by a deterioration in the strength of the Renminbi – the fact that the People’s bank has ‘allowed’ the currency to go through the psychologically important 7 against the dollar is significant. For what its worth I think the trade wars are also a convenient excuse for a failure to meet Chinese growth targets – ‘blame America’ has been a convenient excuse for economic problems for politicians from William Pitt to Hugo Chavez.   

But – as implied by the rate cut – the increase in tariffs will also cause a decrease in economic activity, less trade, less consumption, less manufacturing.

So inflation and a simultaneous economic slowdown – stagflation as we used to call it when I was growing up (Britain, 1970s, great music, rubbish everything else)  – and a further nail in the coffin of the Phillips curve? The famous curve, and most central banking theory, is predicated on the idea that inflation and economic downturns are mutually exclusive, something that no-one worried about when it was growth without inflation.

But what if we wake up tomorrow to a tweet announcing that peace has broken out in the China-US trade negotiations? Back to business as usual? That’s certainly how the stock market will take it. 

But I think not for two reasons.

One is that this has demonstrated the vulnerability of global supply chains. This is something that we have seen already in parts of Europe – where supply chains had become very heavily integrated cross border since the 1990s - German manufacturers are now starting to reduce their reliance on Russian and Eastern European intermediate manufactured goods.  The announcement recently that all US bound iphones could be produced outside China was symptomatic of companies putting reliability of supply chains above lowest cost. That is inflationary and won’t go away.

Another is inflationary expectations. Some have argued that the low inflation/strong growth combination is a result of firmly anchored inflation expectations – admittedly that’s mainly a self-congratulatory argument by the Fed.  Now perhaps the anchor has come lose. Strong labour market, expectation of price rises? Time for some wage hikes? A self-fulfilling prophecy.


Written by Richard Kemmish 


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